Industry Trends Might Not Favor Home Depot Much Longer

Home Depot's  (NYSE: HD  )  underlying business is performing well, which should come as no surprise considering the company's strong history. However, certain trends might indicate that a slowdown will surface over the next few years.  

Industry trends

A significantly reduced supply of homes throughout most of the United States, combined with low mortgage rates, have led to a strong housing market. Some people even refer to it as a housing bubble on steroids. However, according to Market Watch, the 30-year fixed mortgage rate on Zillow Mortgage Marketplace just rose to 4.5% from 4.31% a week earlier. 

Most realtors agree that as long as the 30-year rate stays below 6%, demand will remain high. This is especially the case if the 30-year climbs slowly, as it will force potential home buyers to act to lock in low rates before those levels get too high.

All of this is positive for Home Depot. When people buy homes, they tend to spend a lot of money on those purchases. Another positive sign is that new home sales jumped 8.3% in July. Therefore, people are likely to spend more money at Home Depot in the near future, as well as at Lowe's (NYSE: LOW  ) and Lumber Liquidators (NYSE: LL  ) . More on the latter two soon.

Positive comps and raised guidance

Home Depot's comps increased 10.7% in the second quarter, mostly thanks to an improved housing market. Home Depot also raised its FY 2013 EPS guidance to $3.60 a share from $3.52. However, analysts wanted to see $3.64. Therefore, the raised guidance wasn't an overall positive. And Home Depot will have to contend with high expectations in the second half of the year, as results will be compared to the previous year, which included hurricanes Irene, Sandy, and Isaac. 

Other important numbers

Home Depot's customer transactions totaled 393.2 million in the second quarter, a substantial increase over 374.9 million in the year-ago quarter. Average ticket also jumped to $57.39 from $55.02. These improvements are likely related to an improved housing market, and to a smaller extent, a bullish stock market. While not all of the population is reaping the benefits of the enormous bull run in the stock market, millions of people out there have benefited. This leads to excess capital, which is often used for home upgrades and repairs. 

Home Depot currently yields 2%, and it's in the early stages of a $1.5 billion accelerated share-repurchase program. It has also spent money on innovation, recently launching its Buy Online, Ship to Store program. This initiative will offer more buying opportunities for consumers, having the potential to aid the top line.

King of the hill

Home Depot isn't just the largest company of the three businesses mentioned in this post; it's also the best for the time being. If you look at key metrics, they paint a clear picture:

 

Forward P/E

Net Margin

ROE

Dividend Yield

Debt-to-Equity Ratio

Short Position

Home Depot

18

6.21%

27.50%

2.00%

0.78

1.40%

Lowe's

17

3.97%

13.86%

1.60%

0.68

1.70%

Lumber Liquidators

29

6.97%

25.77%

None

0.00

25.10%

If you look at Home Depot versus Lowe's, the former is stronger in several areas. Both companies are similar in valuation, debt management, and short positions, so those are a wash. However, Home Depot makes more profit per revenue dollar (net margin), generates more profit per investor dollar (ROE), and offers a higher yield.

Lowe's is attempting to steal market share anyway it can. It recently acquired Orchard Supply Hardware Stores for $205 million in cash after Orchard filed for Chapter 11 bankruptcy protection and no competing bids materialized. This acquisition will increase Lowe's square footage in California, where the retailer's exposure is well behind Home Depot. The deal will lead to Lowe's adding 72 stores throughout the state.

Many investors will point to a strong housing recovery in California as a major positive. However, a large portion of the housing boom in California has been thanks to investment firms (and foreign investors) buying properties, not families looking for starter homes or upgrading to larger dwellings. That being the case, the housing boom in California should be looked at with at least some skepticism when it comes to long-term sustainability.

You might have noticed that Lumber Liquidators, best known for hardwood flooring, has some impressive key metrics, including a high net margin and ROE, as well as no debt. However, Lumber Liquidators is a much smaller company, which means it is not as resilient to steep stock market corrections as rivals Home Depot and Lowe's.

This fact, combined with the stock trading at 29 times forward earnings, is likely why the short position is so high. It should also be noted that Lumber Liquidators isn't a threat to Home Depot or Lowe's.

Conclusion

The housing market continues to improve, but whether or not this trend is based on real organic growth and sustainable should be questioned. Therefore, investing in any of the aforementioned companies could be risky. On the other hand, trends remain intact for the moment. If you want to try to squeeze out some more gains before the trend reverses itself, Home Depot should be your best bet.

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